The Big Short and the Bigger Myth About Fannie and Freddie

It was inevitable that “The Big Short,” the screen adaptation of Michael Lewis’s book on the 2008 financial crisis would reopen yet again the debate about what caused and exacerbated the catastrophic collapse. However, Peter Wallison’s assertion in an op-ed yesterday on InsideSources that it was entirely Fannie Mae and Freddie Mac’s fault just doesn’t hold up.

I consider Peter a friend and respect his intellect. That is why his dismissal of the film as Hollywood fiction is dismaying to me. To be sure, any time Hollywood takes up current or historic events there will be artistic license that audiences should keep in mind. However, the central premise of the book and film version of The Big Short, that greed and reckless gambling by private sector investors was a driving force of the market meltdown, is correct. Wallison has it backward when he contends that Wall Street’s actions were subordinate to the policies of Fannie Mae and Freddie Mac in precipitating the crisis.

This much is true. In the mid-1990’s, after weak legislative reform of the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, these firms began to subordinate their historic and effective public roles as countercyclical providers of liquidity to the mortgage market and began to place profit growth ahead of their utility mission. Still, it was not until the Wall Street banks ramped up their private label securitization and the GSEs began losing market share in 2004 that they lowered their standards and became meaningfully exposed to questionable loans. However, the GSEs neither originated the subprime loans at the heart of the crisis. In fact, it was not until the crisis was upon us, when Secretary Paulson forced the GSEs to step in and absorb some of the worst loans made by Wall Street (in an effort to protect the systemically-risky, Too-Big-to-Fail banks that had led the race to zero) that the GSEs began taking meaningful losses on low-quality mortgages. You can thank mortgage bankers and other market players for these products.

If one looks at the delinquency and default levels of agency loans versus the overall market in 2009, once the dust had settled, it was clear that Fannie and Freddie were actually not the chief culprits in the disaster. Fannie’s inventory of loans considered seriously delinquent amounted to three percent of outstanding loans and Freddie’s inventory of such loans was a mere 2.3 percent. Meanwhile, subprime adjustable rate mortgages (ARMs) represented 34 percent of the outstanding loans. Overall, subprime loans made up 23 percent of the mortgage debt in the market.

It is true the GSEs, as a result of their indispensable role in buying up and packaging loans for resale to create liquidity, were major players in the mortgage market. However, this actually turned out to be a good thing. On a blended basis, serious delinquencies in the market overall were just over six percent of the country’s mortgages at the time. In essence, it was the banks that underwrote mortgages they never should have been offered in the first place. That is why they were fined by the Justice Department.

In his commentary of the movie, Wallison explains how misguided actions by Congress and Administrations beginning in the 1990s muddled the missions of Fannie and Freddie. On this, there is some common ground in our perspectives. As I warned in my 2001 paper, “Housing in the New Millennium: A Home Without Equity Is Just a Rental with Debt,” and also pointed out in a recent paper, the savings and loans crisis of the late 1980s prompted the creation of a split-regulatory framework and dual mission for the GSEs. The situation was compounded when international regulatory changes brought more capital and more leveraged risk into the mortgage marketplace through changes in treatment of private label mortgage-backed securities. By 2007, a murky mission for the GSEs and their exposure to private-market arbitrage did indeed put them on unsteady footing. However, the conclusion one should draw from this chain of events is that Fannie and Freddie reflected a breakdown in the system but did not cause the breakdown. This, by the way, was the conclusion of the National Commission on Causes of Financial and Economic Crisis, on which Wallison served. “We conclude that these two entities contributed to the crisis, but were not a primary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis,” the majority of bipartisan commissioners wrote. Granted, Wallison dissented so he deserves some credit for consistency. However, subsequent developments raise new concerns that should cause anyone to rethink what to do going forward.

Leading up to the crisis, I was concerned about the GSE’s credit risk and Wallison was concerned about liquidity risks. Then, as now, I believed the implied government backstop needed to be backed up and paid for while Wallison insisted a better solution would be dismantle the GSE’s altogether and privatize their function.

However, what concerns me more today is that there is increasing concentration in our financial system and a significantly increased implied government guarantee behind our largest banks. Eight years after Too Big to Fail became part of our financial lexicon, five banks control 40% percent of the country’s total deposits and the number of other large banks (over $10 billion in assets) has grown from 76 in 2000 to over 100 today. Those other large banks now hold another 40% of U.S. deposits. All of this has occurred as the number of small banks (who are typically more responsive to their local market customers) hold only 20% of deposits and have declined in number from 8,200 in the year 2000 to 5,900 today. These behemoths have significant advantages over the other 3,500 banks in the U.S. If we dismantled Fannie and Freddie, these banks would be the biggest beneficiaries. In Wallison’s insistence that Fannie and Freddie caused the financial crisis, he overlooked the myriad acts of irresponsibility by Wall Street and other private sector actors and omitted any mention of what could happen if we concentrated mortgages in huge banks.

The Big Short tells a story in cinematic style and so it is reasonable to pick apart various scenes and portrayals and the suggestion that only a handful of people saw the crisis coming. But it is not purely a work of fiction or fantasy. Peter Wallison’s assertion that blame for the 2008 financial crisis rests primarily with Fannie and Freddie is.

About the Author

Josh Rosner is managing director at independent research consultancy Graham Fisher & Co. He is the co-author of the New York Times Best Seller "Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon."

21 responses to The Big Short and the Bigger Myth About Fannie and Freddie

The bad loans didn’t bring down the system – It was investment banks selling insurance premiums that they thought wouldn’t go bad that brought down the TBTF banks. TBTF banks would have $50 million in a portfolio and they were selling their own insurance equivalent to $50 billion in premiums that it wouldn’t go bad – the investment banks weren’t even smart enough to ask ‘why are all these hedge funds shorting these portfolios’. They didn’t care, they had turned banking into an insurance scam, and the scam was being played on them. Pathetic. My question “WTF did that have to do with the GSE’s?” Answer, nothing.

Good article to dispel the myth and propaganda that FnF caused the 2008 crisis.

Many companies abused the system to profit themselves and they blamed FnF to hide their crimes. The massive campaigns of propaganda did the job of painting FnF as villains of 2008 crisis. If FnF were not to become profitable and if FnF were to be liquidated, all these crimes would not have become public.

One critical aspect most people seem to ignore is, it is the FnF seizure and conservatorship that triggered the 2008 crisis instead of preventing it.

Economy needed support from Gov. But these people went on to punish based on their ideologies and where it was required to protect their friends. These people kept on telling that they wanted to punish all these bad companies (competitors). Protecting taxpayers was last thing in their mind. The punishment was highly targeted on bad companies (competitors ). FnF siezures, Conservatorship, Gag order, SPSPA, SPSPA sweep amendments are all severe punishment for FnF and FnF shareholders. This has nothing to do with protecting taxpayers.

2008 crisis was clearly preventable with timely Gov measures. But they relied on free market self regulations and waited until the panic started. Then they started using bazooka instead fire extinguishers.

Facts support the theory that FnF never needed SPSPA credit.
Conservatorship was imposed as a punishment and not as a help. With Conservatorship they threw out the baby along with the bath water.

Hard working people have paid heavy price with loss of jobs, loss of homes, loss of life time savings and worst of all their hopes in American dream. The loss of Hard working people has turned out to be gains of one percent.

FnF did NOT contribute to 2008 crisis. FnF saved the nation from worst economic meltdown caused by the very same reckless people who were supposed to prevent it.

You too are apparently seeking a “causal nexus”. Please see my comments on the Peter Wallison piece.

Causal Nexus—THE FATALLY FLAWED “GSE BUSINESS MODEL”

“ This is not the kind of story that
Hollywood likes — no greed, no evildoers, not even any humor…”

I beg to differ. There is no doubt in my mind (after 20 years
of litigation on the subject) that the “GSE Business Model” is a theft by
deception scheme of a dimension that we have never seen before with the American taxpayers as victims. Every creditable scholar on the subject agrees that the Model is “fatally flawed”. Fatally flawed for a million reasons if you have a problem getting by the first
reason…….the government guarantee.

It is illegal to sell something which does not fulfill the
basic functions advertised.

Yet the GSEs partners with financial institutions to promote
the GSE Business Model that George Soros said “it simply does not work”. The “Big Short” missed this point in the story. The causal nexus in the meltdown is the GSE Business Model. The Model simply does not fulfill the basic functions advertised

It is easy to recognize the profiteers depicted in the “Big Short” as individuals like the deceased investor’s widow coughing up a $7.2
Billion dollar check in the Madoff scheme. We need a guy like Irving Picard to go after the people involved in this largest theft by deception scheme in history.

Fact is, there is no more an official guarantee re the GSE’s than there is for banks. Based on your assertion of an implicit guarantee, the entire US banking system is flawed since they have proven to be TBTF. Fine, you have a right to your opinion but do you have an easy to implement, low- risk alternative model to replace this “flawed” one that has been around for well over over a half century?

Fred, it is the “GSE Business Model” that is fatally flawed and one of the reasons is the fact that the TBTF institutions are “player/partners” in the Model.

I see from your past comments that you were “wiped out” in 2008, then you decided to gather what was left to invest along
with the hedge funders called “vultures” on the comeback of a “fatally flawed” GSE Model. As the lawyers put it, “you knew or
should have known”. The Model was fatally flawed on day one of their existence. Guess what, you apparently made the same mistake twice in an attempt
to recoup.

As a small business man, I have learned early on that if the government is involved run the other way. It is only common sense.

As far as an alternative, let’s go back 50 years and get the government out of the mortgage industry and let free enterprise govern the marketplace. Back then there were plentiful 30 year mortgages, banks were competing in the market place until the subsequent roll out of the GSE Business Model backed by the implied/explicit guarantee killed the competition.

The nonsense narrative that somehow we
can’t get mortgages without the government violates every free enterprise
bone in my body.

Josh Rosner, the author of the article, keeps insisting that the GSEs, Freddie Mac and Fannie Mae were not the real problem, that it was “Wall Street Banks” who created the meltdown. It would be a great movie (if it were true). Rosner leaves out the most important part: why were the banks making subprime mortgages in the first place? Rosner’s and the Leftists’ standard reply is, “They were GREEDY!”. So, in Rosner’s world, you have greedy local bankers who decided that they would start lending money to subprime borrowers who posed a greater probability of default on the loan and THAT would make the banks more money. If Josh Rosner thinks that banks operate that way, he knows NOTHING about the banking industry. Out here in the hinterland, the old joke is that banks will only lend you money if you don’t need it. Why would a bank lend money for risky loans? Answer is, they were coerced by the Clinton administration which threatened prosecution if banks didn’t start lending money to EVERYONE for home ownership. To protect themselves from the higher rate of defaults, the banks bundled the mortgages and passed them on (sold them) to other institutions. Paulson saw the looming problem and order the GSEs to buy those bundled mortgages. The rest is history because when the price of homes sky rocketed due to demand and gasoline went toward $5.00/gallon, those subprime folks had to decide on buying fuel for the car or missing some mortgage payments. IF you have to work every day, you’ll buy gas to go to work and hope you can make a deal with the bank or sell the now-too expensive home. That’s the story you’ll NEVER hear from Rosner and the Democrats.

9. the failures of credit rating agencies were essential cogs in the wheel of financial destruction.

Answers to Questions posed to the FINANCIAL CRISIS INQUIRY COMMISSION:

1. CRA was not a significant factor in subprime lending or the crisis.
2. Fannie Mae and Freddie Mac contributed to the crisis, but were not a primary cause.
3. capital availability and excess liquidity did not need to cause a crisis.

First, to pin this crisis on mortal flaws like greed and hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis

Second, we clearly believe the crisis was a result of human mistakes, misjudgments, and misdeeds that resulted in systemic failures for which our nation has paid dearly.

We do place special responsibility with the public leaders charged with protecting

our financial system, those entrusted to run our regulatory agencies, and the chief executives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no.”

I stand by my comments and they are factual. To rely on the opinions of the FCIC (under the Obama regime, which absolutely has an “agenda” to demonize the private sector) is to place your conclusions (“we clearly believe the crisis was a result of human mistakes, misjudgments, and misdeeds”) on a “commission” that is unaccountable to the public or the public’s representatives. Again, ask yourself WHY a bank would think that making risky loans was a sound business practice. Banks loan money to those who have a good possibility of repaying the loan, not to folks who, as a group, have a higher risk of default. Banks deal in money; they aren’t real estate agents. The comments of the FCIC ignore the complicity of the Clinton administration and AG Janet Reno and throw out a bunch of specious “reasons” (” No one said “no.” “). Of course not! Reno made it clear that Clinton’s ideology was to have EVERYONE become a homeowner and if the loans weren’t forthcoming, the DoJ would take action. That is government coercion.

Gov seizure of FnF and putting FnF under conservatorship was the worst and most irresponsible decision.

Initially Gov officials publicly announce that FnF are safe and sound and there is nothing to worry. Within weeks they seize FnF and put under conservatorship. These contradictory events triggered total financial meltdown.

“Why would a bank lend money for risky loans? Answer is, they were coerced by the Clinton administration …”

What risk did the banks have? They repackaged and pawned off the risk to others, incorrectly (fraudulently?) hiding the risk. You said all this in your next sentence, so it’s not like you’re unaware. Your thesis might be worthy if the big banks didn’t pile onto the scheme with abandon, which they did.

So the question out in the hinterland needs to be rephrased as “Why *wouldn’t* a (bad, greedy Wall Street) bank lend money if they found a way to pass off the risk?”

Your changing the subject from Wall Street banks (“Josh Rosner … keeps insisting that … it was “Wall Street Banks”), to local banks (“in Rosner’s world, you have greedy local bankers…”), seems to be implying that banks were actually the originating loan sources, rather than sloshes of outside money (think pension funds) that big Wall Street banks couldn’t resist putting into unethical schemes. If only …

We all now know how the dog was beat, saw who did the beatings (as there were more than one individual involved), and when. Stop blaming the dog for the beatings and do something about the problem already! As always, eventually the truth will win out. And those pushing their own agenda, like Wallison, will be remembered for the fools and puppets that they are.

The collusion between the federal government and banks with the Federal Reserve, FDIC, FHA, HUD, Freddie Mac, Fannie Mae, Community Reinvestment Act and more is what led to the financial crisis.

When government gets in bed with big business we get: ratings agencies rubber stamping investments, regulators looking the other way, banks giving liar loans, the government bailing out banks and taxpayers paying for everything.

@Richard Davet It is possible we may be on two different pages here and not entirely at odds. But then again, maybe we are. Your thorn-in-the-side view of the GSE as a “fatally flawed” model reflects an economic and political perspective and in my opinion is peripheral and irrelevant to the litigation and therefore to me. My background is special education, music and meditation. I have no interest, let alone expertise in business/finance. It’s not in my DNA. For me, the issue here is simply one of fairness and adherence to the Rule of Law. To suggest that I should accept my loss as a lesson learned for making a bad investment based solely on the contention that the GSE model is not a viable option is to ignore entirely the legal implications of which I was keenly aware of then and even more so now since closely following every development for the past several years. To say that I made the same investing mistake twice adds insult to injury.

There are those that argue the IRS is flawed (probably a hundred times a
day!). Be that as it may, law-abiding citizens honor the system, strong
negative opinions not withstanding. Why? Because they are just that–
opinions. The law says pay, we pay. It is the order of business because we are a country governed not by opinion but by laws.

By Gov decree the GSE’s were created as private entities despite opinions
to the contrary. Gov sponsorship does not negate the fact they are
documented as private entities. I see no * denoting “private–but…”

My fault/loss regardless because I should have known better than to invest?
I and thousands of others have purchased legally sanctioned securities,
circulated unhindered, without any official statement or even a warning
that they were in fact worthless. Not in some shady back room deal or
black market but in broad daylight in full compliance with the SEC and
with the apparent blessing of the Gov. Turning a blind to the trading
of “worthless” shares is no different than ignoring/allowing the
circulation of bogus Andrew Jacksons in the marketplace–negligent at best,
fraudulent at worst. My decision to become a shareholder was actually a
last-ditch effort to regain life savings that I had foolishly lost in the
collapse. While others saw a prohibitively high-risk investment I decided
to go for gold with a huge potential upside. Does that brand me a greedy
vulture or morally corrupt? Ironic, since I took the chance
based on my faith in God, country and constitution with the hope and
expectation the nation would survive and prosper.

I confess that my technical knowledge in matters of Law is no better than
my grasp of economics, but I have a sixth sense for knowing whom to trust
and a nose for BS. A slew of lawsuits not to mention highly esteemed legal
scholars as well as economic experts (Epstein, Macey, Fiderer, Isaac etc.)
decry the takeover. Show me a more creditable source on the 3rd Amend sweep than the Honorable Chief J. Steele who is leading the charge in condemning it an “absurdity” (from day one of its existence-to paraphrase you). I am supremely confident that truth and justice will eventually prevail,
especially after reading his exhaustively thorough, no-holds-barred brief
just recently filed in DE. To the guilty I say–read it and weep!
The Fat Lady is about to sing.

Josh-
Fantastic article. You are one of the few people I know that is honest, fair and tells it like it is. No ideology. No bias. Thank you. It’s difficult if not impossible to debate when one side is dishonest. Although I could write possibly a hundred rebuttals I’ll just ask the other side two simple questions for now. 1). Why were the banks sued or settled for tens of billions of dollars? 2). As of this date, exactly how much taxpayer money has been lost in the past 70 years?